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Environmental, social and governance (ESG) investing, an investing strategy that considers factors such as carbon emissions, supply chain management and business ethics, has become increasingly widespread. According to the U.S. SIF Foundation, one fifth of the total assets under professional management in the United States in 2016 used sustainable, responsible or impact investing strategies. The ESG trend is global, with 1800 investors across 50 countries signing the UN Principles of Responsible Investment and committing to incorporating ESG issues into their investment decisions.

The growth in ESG investing is in part due to shifting market demographics and expanding ESG performance data, analytics and research. As millennials gain more prevalence in the market, the demand for ESG investing has increased. Firms have been able to meet the increased demand for ESG investments due to the enhanced availability of ESG performance data. Organizations like the CDP collect data on corporate ESG performance while MSCI ESG Research and Sustainalytics utilize this data to evaluate investments and companies across ESG criteria. According to the Governance and Accountability Institute, around 85 percent of Standard and Poor’s (S&P) 500 companies have published ESG information. This speaks to the shifting standards of corporate ESG disclosure and the increasing pool of data available to investors.

Despite ESG investing’s rising popularity, its effects on investment performance are often debated. Common methods of integrating ESG factors into investment decisions are negative screening (removing companies or sectors that fail to meet certain ESG thresholds) and positive screening (selecting the companies with strong ESG performance). Many investors worry that these restrictive methods will inhibit portfolio diversity and negatively impact returns. However, numerous studies have shown that strong ESG practices are indicative of high quality management, resource efficiency and a lower cost of capital—all which contribute to robust corporate financial performance. As a result, 80 percent of financial managers surveyed by the U.S. SIF Foundation cited financial performance as one of the main reasons for implementing ESG investing.

I contribute to the dialogue on ESG investing’s efficacy by performing a factor analysis of an ESG index (the MSCI ACWI ex Fossil Fuels Index), 21 U.S. ESG mutual funds and a traditional investment index. Financial factors are drivers of securities’ risk and returns, such as the U.S. equity market or the price of crude oil. One model to analyze a fund’s exposure to financial factors consists of analyzing the fund’s returns against the factors’ returns and examining their coefficients. I made a linear regression model using data from MSCI, the Federal Reserve Bank of St. Louis, Thomson Reuters, and the FinMason investment analytics platform from November 30, 2010 to February 28, 2018 to assess whether ESG funds have a significantly different exposure than a traditional index (the MSCI ACWI index) to a variety of factors: the U.S. equity market, the U.S. dollar, the price of gold, the price of crude oil, the Fama-French Value Factor and the Fama-French Small Cap factor, the Japanese equity market, emerging equity markets, the Chinese equity market and developed European equity markets.

The ESG funds had a range of factor exposures, highlighting that ESG investing is a broad category. For example, the ESG funds varied in their exposure to oil. Five of the 21 U.S. ESG mutual funds had a negative oil exposure. The negative exposure implies an inverse correlation between the price of oil and the ESG fund’s returns. Three of the 21 funds’ returns were not significantly correlated to the price of oil. Thirteen of the 21 funds had a positive exposure to oil and nine of these 13 had an even higher exposure than the traditional investment index.

The diversity of oil exposures can be attributed partly to differences in the funds’ ESG strategies. The two funds with the highest oil exposures were both Ariel funds (CAAPX, ARGFX). Upon examining the ESG methodologies used to construct all 21 funds, it was apparent that these Ariel funds do not incorporate environmental factors as rigorously as the other funds. According to the U.S. SIF Foundation, Ariel employs “no formal process” for evaluating the environmental impacts of companies and uses no exclusionary screens with the exceptions of weaponry and tobacco production. By using mainly positive screens, companies with low ESG scores are not necessarily excluded. In contrast, the investments with negative oil exposures combine positive and negative screening methods and largely aim to be fossil fuel free, thereby increasing exposure to best-in-class companies while eliminating companies with low environmental scores.

The stringency of the ESG methods also impacts a fund’s exposure to oil. The MSCI ACWI ex Fossil Fuels index had an overall positive exposure to oil despite excluding all the companies that own fossil fuel reserves. One possible explanation for this phenomenon is that many companies in the index, although they do not own fossil fuel reserves, are affected by the price of oil. For example, the ESG index still includes some companies involved in establishing oil pipelines, evidenced by the index’s holdings. Therefore, even if the fund is advertised as an ex fossil fuel fund, the fund’s returns may not be negatively impacted by rises in oil prices because companies may have different definitions of fossil fuel free. If oil exposure is considered an indicator of a fund’s environmental commitment, investors that are looking for an environmentally conscious fund may want to use factor analysis to assess whether the fund aligns with their values.

An ESG fund’s methodology can supplement factor analysis by helping explain to investors why a certain fund has a high or low exposure to oil. For example, the Parnassus Endeavor Fund (PARWX) had the lowest oil exposure of all 21 funds, considers far more aspects of environmental impact than the Ariel funds and excludes fossil fuel companies. Another fund offered by the same company, the Parnassus Fund (PARNX), had the third highest oil exposure and merely avoids companies associated with fossil fuels. Lastly, the Parnassus Core Equity Fund (PRBLX) did not have a significantly different exposure to oil than a traditional investment index. Parnassus’ description of the fund’s strategy does not mention any fossil fuel screening criteria. While all three funds are classified as ESG funds and are offered by the same firm, their methodologies differ in intensity, as reflected in their exposures to oil. If an investor is not able to evaluate the factor exposures of ESG funds, they should scrutinize the ESG funds’ strategies to assess whether the fund aligns with their personal beliefs and portfolio needs.

Whether ESG investing has a positive, negative or negligible impact on returns depends on the fund, as ESG funds differ widely with respect to their investment criteria. The variance in strategy and stringency impact a fund’s exposure to sources of risk and return, yielding different financial performances. As ESG investing rises in popularity, the ESG investing offerings will likely increase. When confronted with these options, investors can consult factor exposures and fund methodologies to inform ESG investment decisions that uphold personal values without compromising financial returns.